The Fed faces a war shock

The Federal Open Market Committee left the federal funds rate at 3.50–3.75 per cent at its March meeting. It had little choice. A war in the Middle East has hit the economy with the kind of supply shock central bankers dread, one that cuts output and pushes up headline inflation at the same time.

The committee reached this range through three quarter-point cuts in the autumn of 2025, made because the labour market was cooling while inflation drifted only slowly towards target. Until the war, the debate inside the Fed was about how many more cuts would follow and how quickly. That debate has been suspended, and the committee is now trying to work out which of its two goals the shock threatens more.

Oil at a hundred, and rising

Textbook doctrine says a central bank should look through a temporary jump in energy prices, since raising rates into a slowdown only makes the slowdown worse. With hundred-dollar oil bearing down on headline CPI and core services prices refusing to cool, the Fed has no room to be accommodating. A cut to support growth could loosen long-term inflation expectations. A hike to lean against oil prices would very likely tip the country into recession.

A supply shock is awkward precisely because it moves the Fed's two targets in opposite directions. A demand shock, such as a collapse in spending, lowers both inflation and employment, and the answer is obvious. An oil shock raises prices and lowers output together, so any move that helps one goal hurts the other. The committee's mandate, set by Congress in 1977, asks it to pursue maximum employment and stable prices, and gives no ranking for the moment when the two conflict.

What history teaches

The historical record gives conflicting lessons. In the 1970s the Fed under Arthur Burns treated successive oil shocks as temporary and kept policy loose, and inflation became entrenched until Paul Volcker squeezed it out with a severe recession in the early 1980s. Research by Ben Bernanke and others in the late 1990s argued the opposite risk: that much of the output lost after oil shocks came from central banks tightening in response, rather than from the oil price itself. The Fed has tried to steer between those two errors ever since.

More recent episodes point towards patience. When Iraq invaded Kuwait in 1990 and crude roughly doubled, the Fed under Alan Greenspan cut rates as the economy slid into recession, and inflation fell back once oil prices reversed. The European Central Bank took the other path, raising rates in July 2008 as oil hit a record and again twice in 2011 as energy prices lifted inflation, and on both occasions it had to reverse course within months. Those cases are the reason central bankers speak of looking through energy shocks.

Why this time is harder

The difference now is the starting point. Inflation has been above the Fed's 2 per cent target for five years, which is long enough for households and firms to wonder whether the target still binds. Core services prices, which depend heavily on wages and rents, have been slow to cool even without an energy shock. Tariffs have already pushed up the prices of goods. A central bank that has spent so long promising a return to target has less credit to spend on patience.

The committee also changed its own framework only recently. In August 2025 it dropped the make-up element adopted in 2020, under which it would have tolerated a period of inflation above target to offset earlier shortfalls. That change was meant to reassure markets that the Fed would not let inflation run. It also narrows the room to argue that a burst of energy inflation can be ignored.

Powell admits the limits

At his press conference Chairman Powell conceded as much. Higher borrowing costs will not get a single oil tanker through the Persian Gulf.

That admission is also a statement of method. Monetary policy works on demand, with a lag of a year or more, and cannot conjure up supply. What it can do is influence expectations: if households and firms believe the Fed will act should inflation spread, they are less likely to build higher prices into wages and contracts, and the Fed may never need to act. Holding rates steady while warning that it is watching for second-round effects is the committee's way of buying that belief cheaply.

Winners and losers from standing still

A Fed on hold favours savers and holders of cash, who keep earning rates well above those of recent years, and banks, whose lending margins benefit from a steady policy rate. Borrowers who had counted on further cuts lose, particularly homebuyers, small firms and companies with floating-rate debt. The dollar tends to hold its value when the Fed pauses while other central banks face even worse trade-offs, which helps American consumers buying imports but hurts exporters.

Standing still is not the same as doing nothing. If inflation rises while the policy rate stays at 3.50–3.75 per cent, the real rate, the nominal rate minus inflation, falls, so an unchanged setting becomes looser in effect with every month that prices climb. That drift is tolerable for a few months of an energy spike. It becomes a problem if the spike lasts, because the Fed would then be easing by default at exactly the moment it needs to show resolve.

What would force a move

The case for a cut rests on the labour market. If oil at this level pushes the economy into recession and unemployment rises quickly, the committee's employment mandate would take priority, and the precedent of 1990 would come back into play. The case for a hike rests on expectations. If long-term inflation measures in bond markets and household surveys start climbing, the committee will conclude that the shock is spreading and act regardless of growth. The data to watch are monthly core inflation, wage growth, weekly jobless claims and the five-year, five-year forward inflation rate. Powell's term as chairman ends in May, which adds a question about who will make the next decision. The Fed will probably sit on its hands until the war or the jobs market forces a decision. Until then, the price of oil sets American monetary conditions and the FOMC mostly watches.